Privatization

By Jr. Robert Poole

SHARE
POST:

“Privatization” is an umbrella term covering several distinct types of transactions. Broadly speaking, it means the shift of some or all of the responsibility for a function from government to the private sector. The term has most commonly been applied to the divestiture, by sale or long-term lease, of a state-owned enterprise to private investors. But another major form of privatization is the granting of a long-term franchise or concession under which the private sector finances, builds, and operates a major infrastructure project. A third type of privatization involves government selecting a private entity to deliver a public service that had previously been produced in-house by public employees. This form of privatization is increasingly called outsourcing. (Other forms of privatization, not discussed here, include service shedding, vouchers, and joint ventures.)

Regardless of the mode of privatization, the common motivation for engaging in all three types is to substitute more efficient business operations for what are seen as less efficient, bureaucratic, and often politicized operations in the public sector. Some have described the key difference as the substitution of competition for monopoly, though some forms of privatization may involve only one provider in a given geographic area for a specific period of time. But because government almost always operates as a monopoly provider, the decision to privatize usually means demonopolization, even if not always robust, free-market competition.

The decision to privatize usually involves money. Governments sell state-owned enterprises to obtain proceeds either for short-term budget balancing or to pay down debt. They turn to the private sector to finance and develop a major bridge or seaport when their own resources are stretched too thin. And they outsource services in the hope of saving money in their operating budgets, either to balance those budgets or to spend more on other services (and occasionally to permit tax reductions).

Classical Privatization (Asset Divestiture)

As recently as the 1970s, many major industries in OECD countries were owned by the state, in keeping with the Fabian Society’s dictum that the “commanding heights” of the economy should be in government hands.1 As is still true today of state-owned enterprises (SOEs) in China and many other developing countries, these businesses were generally run at a loss, subsidized by all the taxpayers. In other words, the value of their outputs was less than the value of their inputs, making them into value-subtracting (rather than value-adding) enterprises. The reasons for this situation were many, but generally they included explicit or implicit policy decisions that—in addition to producing whatever goods or services (cars, steel, air travel, etc.) they were set up to produce—the SOE was also intended to provide jobs, provide its output at “affordable” prices, and accomplish other ends.

The first organized effort to divest SOEs took place in Chile under the influence of the “Chicago boys” during the 1970s’ Pinochet era of economic reform. But the largest and best-known effort was that of Margaret Thatcher’s government in the United Kingdom during the 1980s. Thatcher succeeded in making privatization politically popular while selling off the commanding heights of the British economy: British Airways, British Airports Authority, British Petroleum, British Telecom, and several million units of public housing, to name only a few examples. Thatcher’s political strategy emphasized widespread public share offerings rather than auctions to other private firms. Over the decade, this approach tripled the number of individual shareholders in Britain, giving the policy a popular base of support.

By the end of the 1980s, the sale of SOEs had gone global, inspired in part by the British example. Governments in France, Germany, Japan, Australia, Argentina, and Chile all sold numerous SOEs, and global privatization proceeds ran in the tens of billions of dollars each year. Generally speaking, companies that moved into the private sector were restructured (often with considerable loss of jobs) and turned into value-adding enterprises. In the case of public utilities (airports, electricity, water, etc.), privatization generally led to the creation of some form of regulatory oversight if the company remained a monopoly provider. The privatization wave expanded further in the 1990s, encompassing the countries emerging from communism and many more developing countries. Here, the privatization record was mixed, with many cases of less-than-transparent sale processes (to firms well connected with government officials) and a botched shares-for-debt scheme in Russia that created an instant crop of politically connected billionaires. Still, by the end of the decade, privatization proceeds were well above $100 billion per year, and the cumulative total for the two decades exceeded $1 trillion.

Few people today dispute the value of transforming value-subtracting SOEs into value-adding companies accountable to their shareholders. China, India, and numerous other developing countries continue to prepare and sell SOEs, though this can be a painful process in a country like China, where SOEs have historically provided extensive social welfare services, and neither the government nor the civil society has devised a safety-net alternative. In OECD countries, there are very few industrial SOEs left, although many airports, railways, motorways, and electric and water utility systems are still in state hands (but increasingly being privatized).

Infrastructure Partnerships

The idea of granting a private firm or consortium the right to develop and operate a major infrastructure project is not new. Most British and American (pre–auto era) toll roads of the eighteenth and nineteenth centuries operated on this model. So did the electric streetcar systems and the original New York subway. So, still today, do most U.S. investor-owned utilities, typically operating on fifty- or ninety-nine-year franchises. But apart from those utilities, the idea seemed to die out in most of the world for most of the twentieth century.

The governments of France and Italy revived the idea in the 1960s to develop national networks of tolled motorways, and Portugal’s and Spain’s governments later imitated them. These transport examples inspired the historic Channel Tunnel, a rail link between England and France built in the 1990s. Neither government was prepared to put up the estimated four billion dollars needed for the project, so an investor group eventually succeeded in winning a fifty-five-year concession agreement to do the project privately. The project cost nearly twice as much to build and is generating much less revenue than forecast. But apart from renegotiating the franchise term to ninety-nine years, the company has received no taxpayer bailout; only its investors have been on the hook for the overruns.

That example illustrates one of the principal virtues of the infrastructure franchise model. While governments typically focus on the advantage of being able to get such major projects built without adding to the government’s debt, a more important benefit is risk transfer. Hapless taxpayers should not be burdened with such risks as construction cost overruns and less-than-expected traffic; those are risks the private sector can take on. But in a properly structured “public-private partnership” agreement, risks that the government is better suited to bear (policy changes, “acts of God,” etc.) should remain with the public sector; otherwise, there is likely to be no private-sector partner willing to tackle the project.

This model—often called build-operate-transfer (or BOT)—went global during the 1990s, with the enthusiastic backing of the World Bank and other global development agencies. It was adopted without such prodding in most OECD countries: for example, Australia developed modern toll expressway systems in Sydney and Melbourne; Britain added major bridges and its first tolled motorway; and more than a dozen U.S. states passed transportation partnership laws to facilitate BOT toll-road projects. Development bank reports helped spread the model across South America and southern Asia, with airport, seaport, toll road, electric power, and water/wastewater projects in scores of countries. A major year-end survey in 2003 by Public Works Financing lists 1,369 such projects in 87 countries costing $587 billion that have been financed since 1985. Adding those in the design or proposal stage produces the larger totals of 2,701 projects in 124 countries costing $1.15 trillion.

As with the sale of SOEs, infrastructure partnerships can be done well or poorly. Developers often seek guarantees of traffic or revenue, which undercut commercial discipline and void the desired risk transfer away from taxpayers. On the other hand, political risk can be high in many countries. Governments may impose after-the-fact controls on pricing or may not allow prices to be adjusted to take into account a major devaluation (as in Argentina, where privatized utilities were caught with large debts in dollars but revenues in greatly devalued local currency), or a change of government can lead to the abrupt termination of a previously awarded concession. But despite such problems, the BOT model appears to have become a standard modus operandi in many countries in the early twenty-first century.

Outsourcing

The rationale for outsourcing is that there is a difference in principle between providing for a public service and producing that service. Government may be responsible for maintaining highways, collecting garbage, or operating recreation centers, but just like any private company it is faced with a “make or buy” decision about that service. Economic theory suggests several reasons why outsourcing might be more cost-effective than in-house provision. First, the unit of government with responsibility for the service may not be of the optimum scale to provide the service efficiently. Second, it may lack the required expertise or technology, for various reasons. Third, and probably most important, a perpetual in-house monopoly will have weaker incentives to innovate in order to find more cost-effective ways to operate. Competition to be the service deliverer should produce stronger incentives.

Although outsourcing is still debated politically, the empirical question has long since been answered in its favor. In the 1970s, the National Science Foundation funded the first empirical study, examining the cost and performance of municipal garbage collection under various institutional alternatives. The researchers found that competitive contracting was clearly less costly. Further research during the 1980s and 1990s—by academics, think tanks, and the federal government’s General Accounting Office—reinforced those findings across hundreds of different types of services at federal, state, and local levels of government in the United States. The findings on municipal garbage collection were replicated in a large-scale study in Canada.

During the 1980s, outsourcing became common in municipal and state governments, primarily in the Sunbelt. In California, more than seventy cities joined the California Contract Cities Association. Aiming from the outset to obtain most of their public services via contractual arrangements, these cities contracted either with private firms or with larger nearby governments. In the 1990s, outsourcing was embraced by reform mayors, both Republican and Democrat, in larger and older cities, such as Chicago, Cleveland, Indianapolis, New York, and Philadelphia.

At the federal level, the Office of Management and Budget issued government-wide policies on competitive contracting (OMB Circular A-76) during the 1960s. Aside from an effort to promote this approach aggressively during the final year of the Reagan administration (1988), outsourcing at the federal level waxed and waned until the Bush administration in 2001. Under the President’s Management Agenda, “competitive sourcing” has become a White House priority, with government-wide targets for outsourcing a large fraction of the 850,000 federal positions that the agencies themselves have classified as commercial in nature.

Public employee unions have engaged in large-scale efforts to thwart outsourcing by governments. They publicize individual examples of privatizations that have gone wrong—and there definitely are such cases. Firms seeking government contracts make campaign contributions, and sometimes contracts are awarded via less-than-transparent processes. In other cases, once a firm has won a contract via a low bid, it may seek to renegotiate the contract at a higher price. And there is always the danger that once a firm becomes the incumbent provider, it will persuade public officials that, instead of going back out to bid when the contract expires, they should simply negotiate a contract extension. All such practices undermine the competition-works-better-than-monopoly rationale for outsourcing and may reduce or eliminate the intended savings for taxpayers. Moreover, unless the government becomes skilled at writing solid and measurable performance standards into the contract, it may not be able to ensure that it is getting the full measure of services it expects at the promised lower cost.

These problems are real, but they are arguments for doing outsourcing well rather than not doing it at all. Overall, the continued spread of outsourcing and its increasingly bipartisan acceptance (e.g., by New Democrats such as David Osborne) suggest that the advantages are genuine, despite the occasional failure to do it well.

Conclusion

Privatization encompasses a variety of techniques for shifting functions that have traditionally been wholly in the public sector into the private sector to various degrees. In the case of state-owned enterprises, there is widespread consensus that steel mills, auto factories, and airlines belong in the private sector, and the first decade of the twenty-first century should see most of the remaining SOEs in these areas sold off or liquidated. The track record of large-scale private infrastructure projects is more mixed, with many of these projects (especially in poorer countries) financed with a mixture of state and private capital, which leads to blurred incentives and challenging policy questions. The next decade or two should see continued efforts to fine-tune the allocation of tasks and risks between public and private sectors in these projects.

Because public service delivery is the one area in which labor unions have been gaining ground in OECD countries during the past few decades, we can expect continued battles over outsourcing such services. Recent U.S. controversies over airport screening and air traffic control suggest that these battles will be high profile, emotional, and costly. But to the degree that competition becomes institutionalized in public-service delivery, the performance and cost-effectiveness of those services seem likely to improve, regardless of which party wins a particular competition.

Classical privatization (the sale of SOEs) became such a phenomenon in the late 1980s that several global newsletters and magazines were devoted exclusively to the subject, complete with league tables and aggregate statistics. By the twenty-first century, however, such privatization had become so commonplace that there was no longer a market for these publications. By contrast, infrastructure franchising still supports a specialized newsletter (Public Works Financing), and outsourcing also has a newsletter (Privatization Watch).

About the Author

Robert Poole founded the Reason Foundation, a public policy think tank based in Los Angeles. He is nationally known as an expert on privatization and transportation policy. He was the first person to use the term “privatization” to refer to the contracting out of public services.

Web Sites

Footnotes

The thirty member countries of the Organisation for Economic Cooperation and Development include most Western European countries, the United States, Japan, Mexico, Turkey, Canada, Australia, Poland, South Korea, the Czech Republic, the Slovak Republic, Finland, Greece, and New Zealand. The Fabian Society was a British group, whose most prominent members were George Bernard Shaw and Sidney and Beatrice Webb, that was formed in the late nineteenth century to push for socialism.

Enter your email address to subscribe to our monthly newsletter:

RELATED
CONTENT By Kevin M. Murphy and Jeffrey A. Miron

Can Privatization Improve the Financial Health of the Social Security System?

"Properly understood, privatization has no effect on Trust Fund solvency and thus nothing to do with 'saving' Social Security."
Social Security faces a long-term financial problem. Although the Social Security Trust Fund currently boasts a substantial balance and collects far more in taxes than it pays out in benefits, this situation will change as the Baby Boom generation hits retirement. By 2015 Social Security will be paying more in benefits than it collects in taxes, and by 2039 the Trust...